2008 – A year of uncertainty

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The first issue for 2008 is important because so many markets appear to lack a sense of direction as we begin a new year. Normally I keep my remarks to the economic arena but the apparent dramatic change in the leadership of BOTH political parties may have had an impact on last Friday’s stock market action. The low jobs and high unemployment report created most of the headlines but beneath the surface it’s uncertainty that has so many investors rushing to the sidelines or into the safety of US Treasury bonds.

The song doesn’t remain the same

Last year the EWW projected early that long-term interest rates would begin a dramatic fall after June 30th to a projected level of 3.70% (10-year). Rates did plunge in the second half of the year to a low of 3.84% on November 26th. This year the path won’t be as smooth and will have many twists and turns that will make timing an important part of any interest rate strategy. The inflation fears that have the Fed and commodity players worried will be replaced in the second half of the year with the realization that the economic contraction that began in 2007 has brought a lessening of consumer demand and a deflationary trend not seen for over 25 years. The strong seasonal pattern of rising rates in the first six months of the year followed by declining rates in the second half of the year will be offset by an economy suffering from a lack of credit similar to the Japanese economy in the early 90’s. For many borrowers the availability of funds will be a more important issue than the timing of rate cycles as bank balance sheets become the determining factor for loan programs. Although we have seen a sharp increase in both commercial and real estate loans made by banks in the past few months this is NOT an indication of a growing economy but rather stress in the lending arena as many players try to stay afloat. Friday’s Fed H.8 report showed in purchased deposits and borrowings from banks that must raise capital quickly or cease to exist as normal lenders to the businesses they normally service in their communities. I would strongly urge business owners to have their current bank reaffirm outstanding credit lines and be open to proposals from lenders that have available $$$ for future needs. This year long-term interest rates will fluctuate in a downward sloping range but availability will be much more important than rate to all but AAA borrowers.

Housing

The theme of this letter has always been “we only see life from our own experiences” and that means that most predictions of the future are a function of our past. Bear markets are rare in real estate and as we wrote last year tend to be long and painful affairs. The biggest difference from a bull market is that we don’t see a crash or sharp sudden drop in prices that is almost always followed by an increase in prices that finds new highs within a short period of time. We are in the early stages of a secular (not cyclical) real estate bear market which should see a flattening of house prices for the remainder of 2008 and then another leg down in 2009 washing out all but the bravest of speculators. Unfortunately real estate’s biggest negative is the fact that price discovery is not as easy to determine as that of the stock, bond, currency and commodity markets. This tends to stretch moves both to the up and downside as buyers and sellers move to the sidelines waiting for new information. The other major problem with real estate is that there is no effective way to sell short or bet on lower prices. Most traders of stocks, bonds, commodities, currencies, etc. doesn’t care which direction is next as long as they are on the right side. It places real estate in a position where everyone bets on higher prices and that makes it almost impossible for anyone to be objective about price levels. A familiar refrain from many real estate agents in early 2007 was: “Prices are the cheapest they have been in many months so it’s time to buy….at the end of the year it changed to: prices are the cheapest they have been in a couple of years……in 2009 this will change to: prices are the lowest in many, many years. Buyers in early 2007 are not happy that prices have fallen and if you must buy in the next couple of years it is imperative that your leverage be minimized. I expect the conforming loan limit (417M) to be raised in the next few months (1MM?) which will allow many to refinance their mortgages to lower monthly payments. The current mortgage mess is NOT about sub-prime or option arm resets but the fact that home prices are declining and will continue to slowly fall for a number of years. Many home purchases that were made at 80-90% loan to value are now at 100% or more and can’t be refinanced at any rate unless the lender allows the amount above 100% to effectively be non-collateralized.

Recession

The most often used word in 2008 will be recession. I’m not sure why anyone cares about whether we are in a recession or not….would you change your spending, saving, investment behavior if it was announced the US is in a recession? If yes, be very careful as the official source (NBER) makes the actual designation after we have come out of a recession and at that time it is irrelevant except to economic historians. If you are in the mortgage business it feels like a depression, if you are in the oil business your services are in demand and the average consumer’s confidence is more about their individual situation and the recent trend of the stock market. The recession talk has created uncertainty for investors and become a hot topic for those running for election. We will learn next year that the recession began in late 2007 but that does nothing to help forecast trends for this year.

This year’s surprises

3) Commercial real estate becomes a much bigger problem than residential as the government can influence lenders ability to make home loans. With home prices stabilizing we should see relief from the twins (Fannie & Freddie) who desperately need to increase their capacity to loan funds to home and apartment buyers. The commercial market is driven by the supply of available funds at competitive interest rates, 1031 tax advantaged transactions and foreign demand caused in part by a cheap dollar. The mortgage backed securities market which funds the majority of these transactions has been “frozen” for almost six months and I see a very slow thawing process that will halt many possible sales from being completed this year.

2) The dollar will surprise the majority and increase in value especially against the British Pound currently trading at 1.97. The lending and mortgage problems will soon have a dramatic effect on the British economy and the pound could easily fall to 1.80 in the next few months. With English short-term rates sure to decline, the differential between US and British rates will narrow thus driving funds back across the pond.

1) The best bet of the year comes from the US where a widening yield curve seems to be the only chance the Fed has of slowing the fall in economic activity. This will also give banks the opportunity to lend with cheap funds from the Fed. Mr. Bernanke will continue his easing policy and lower the Fed Funds rate to at least 3% before the end of the year. The 3 month T-Bill rate closed today at 3.24% and the ten year at 3.84% or a spread of 60 basis points. The 2 year/10 year spread is 108 basis points and a continued Fed ease should drive these spreads to much wider levels. Unless you believe the Fed is going to turn around quickly and begin to tighten (raise short rates) due to economic strength? The Fed’s monetary course for the remainder of this year is set. The direction of the curve is up and once in motion the yield curve tends to trend in the same direction for years.

This is a year where the biggest profits will arrive for those who take the least amount of risk. It’s time to get behind the Fed and its 2008 easy money policy and reap the rewards from the uncertainty of most other global markets.